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September 28, 2014

Is this a
crazy idea? Why should you have a checklist to reject stocks?

You will
generally find ten tips to select the next ten bagger, but not many write on
how to reject stocks.

Let me first
try to convince you why this a sound idea –

The problem
of abundance

A typical
well diversified portfolio tends to have 15-20 stocks (anything more does not
reduce risk any further).Let’s assume
that the holding period is 2-3 years per stock. So in effect one needs to find
and replace 5-7 stocks per year in the portfolio.

Even if one
assumes a much higher level of diversification, I cannot see a scenario where
one is replacing more than 10-12 stocks per year (as an investor and not as a trader).

We have
around 5000+ companies listed in the stock market and a selection of 10-12
stocks means that you will reject 4990 stocks (if you were able to have a look
at all the companies each year).That is
around a 99%+ rejection rate. Even if you were to play around with the number
of stocks you can analyze each year and the number you end up selecting, I
cannot envisage a scenario where you will reject less than 95% of the stocks
you review.

If you are
rejecting stocks most of the time, does it not make sense to have a checklist
to make the process more efficient and robust?

Finally a
corollary to my point –The main problem is that we are not limited by choice,
but by time and effort.

Building the
framework

To design a
rejection checklist, it’s important to understand what we are looking for and
identify factors which negate that.

At the risk
of oversimplication, I would say a long term investor is looking at high rates
of return for a long period of time. Putting it quantitavely, I would say that
I am looking at a CAGR of 26% per annum for 3-5 years or longer if possible.

So what are some
of the characteristics of a company which can deliver these kinds of returns?

-The
company operates in an industry with above average growth rate which means that
the industry is growing atleast at 15%+ rates (higher than the GDP).

-The
company is able to earn a high rate of return on capital (atleast 15% or
higher) for a long period of time (sustainable competitive advantage)

-Company
is led by a competent and ethical management

-The
company is selling at reasonable valuations

Easier to
reject stocks

You must have
noted that I have omitted a lot of factors which go into selecting a winning
stock and that’s precisely my point. Selecting a profitable stock is a complicated
Endeavour and one can write books on it and still not cover all the points
needed to identify a profitable idea.

On the
contrary if one inverts the idea and looks for an approach on how to lose
money on stocks, the list becomes surprisingly small. This is also called the Carl Jacobi maxim
on inversion

So let’s look
at how we can select stocks to lose money

-The
company operates in an industry which is in a terminal decline (fixed line
telephony) or is highly cyclical, commodity in nature and with very poor return
on capital (metals, sugar, airlines etc)

-The
industry is subject to a lot of change (regulatory, competitive or
technological) which causes several companies to fail or loose money due to
sudden change in the competitive scenario (telecom, mining etc)

-The
company is managed by an unethical and incompetent management (do you need
examples here?? – just look around )

-The
stock is purchased at high valuations in a cyclical industry right at the peak
of the business cycle. To add insult to injury, the company is managed by an
unethical and incompetent management. This combination of factors is guaranteed
to loose atleast 50-60% of your capital if not more

That’s it! I
think the above four factors will help you weed out 80% of the stocks in less
than an hour

Is it
comprehensive and works 100% of the time?

Of course,
this list is not comprehensive. I can come up with a lot of additional points,
but I can say that these broad criteria can be used to eliminate a lot of
companies at the first glance.

Some ofyou may point out that you are aware of a company
XYZ with above characteristics, which gave a 50% upside or has even been a
multi-bagger.

My counter
point is – Do you really want to search for a needle in a haystack when there
are often gems lying around? If your idea of fun is to find that nugget of gold
in a pile of manure, then welcome to my world. I have engaged in it often and
the results are not great compared to the effort put in. In addition if you are
not a full time investor, then it makes all the more sense to focus your
limited time on good opportunities.

The benefit of
my mistakes

The list I have
shared is not something I have just dreamed up while sipping coffee. I did a
small exercise of listing of my failures for the last 15+ years and found a few
common threads among all of them.If I
boil it down, it comes down to the four points listed above.

Now, I know
some investors who are able to make good returns by investing in cyclical or
commodity stocks. Some others are able to do well, even if the management is
not great. However I am quite sure that a majority of investors cannot achieve
superior results if they decide to ignore one or all of the four points listed
above.

Let me make
another bold claim – if you want to lose 90% of your money, buy a highly
cyclical and commodity type company at high valuations at the peak of the business
cycle and run by an incompetent and crooked management. You will be guaranteed
this result. How do I know – I tried it
a few times and have never failed to loose my shirt (and other garments!)

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

Makes perfect sense. But from a time perspective if one applies the following filter Combined ranking of low PE and High ROE (Magic formula), Mkt cap filter, Rate of growth for atleast 5 years and then evaluate the promoters and regulations perspective i believe it will save you a lot of time...

Nice post. I guess another thing is no matter how good the company is, if the valuations are too high, stay away. There are people who bought infra-growth stocks in 2006 at 50 times earnings. I wouldn't.

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Disclaimer

I do not provide investment advisory service via this Blog. The stocks discussed on the blog and each post are for educational and discussion purposes only and are not recommendations to buy or sell stocks.I may or may not have a position in the stocks discussed on this blog. For any investment decision, please contact a certified investment advisor.